Inca, Inc.*

Inca, Inc., operated and licensed others to operate quick-service restaurants under the name Pedro's. The menu featured chiliburgers, along with a limited selection of Mexican foods. The walls of each restaurant were decorated with the exploits of Mexican heroes. The first Pedro's was opened in Santa Fe, New Mexico, on June 9, 2003. Ten years later there were 298 restaurants in operation in 27 states, of which 111 were operated by the company and 187 by franchisees. In addition, 4 restaurants were under construction by the company, and 64 by franchisees. A balance sheet as of June 30, 2013, is included in Figure 1.

Each Pedro's restaurant was built to the same specifications for exterior style and interior dcor. The buildings, constructed of yellow brick, were located on sites of approximately one acre. The parking lots, depending on the exact size and shape of the land, were designed for 30 to 35 cars. The standard restaurant contained about 1,900 square feet, seated 81 persons, and included a pickup window for drive-through service.

Locations were chosen in heavily populated areas, since success depend-ed upon serving a large number of customers.

All of the restaurants offered the same menu. Three sizes of chiliburgers were featured: the Gaucho (quarter pound), the Soldado (half pound), and the Matador (three-quarter pound). The names were integrated into the company's advertising. On television each commercial gave special attention to one of the three themes.

The prospective franchisee signed a document that included the option of operating a specified number of Pedro's restaurants in a prescribed geographical area. Each new location required an initial payment of $18,000. In addition, a royalty of 5 percent of gross sales was specified. It was also stipulated that franchisees must spend at least 2 percent of gross receipts on local advertising. Inca, Inc., believed that properly trained employees were the key to success. Therefore, managers and company trainees were required to attend a three-week program covering all aspects of company operations. More than 600 people were graduated from the school during 2009.

Inca, Inc., planned to begin construction on five new company-owned restaurants during 2014. The exact size of the buildings had not been determined, although the specific sites had already been selected.

Figure 1

INCA, INC.

Balance Sheet

As of June 30, 2013

(in thousands)

Assets

Current assets:

Cash .................................................................................................$12,026

Accounts receivable .........................................................................1,646

Inventory ..........................................................................................512

Other current assets ..........................................................................1,872

Total current assets ...........................................................................16,056

Equipment and property:

Buildings ..........................................................................................10,208

Leasehold improvements .................................................................4,826

Restaurant equipment .......................................................................11,630

Motor vehicles .................................................................................1,188

Office equipment ............................................................................464

Lease rights ......................................................................................542

Less: Accumulated depreciation ..................................................3,104

Total equipment and property ..................................................25,754

Land10,606

Construction in progress ......................................................................434

Other assets ..........................................................................................1,566

Total assets...........................................................................................$54,416

Liabilities and Stockholders' Equity

Current liabilities:

Notes payable to banks ....................................................................$316

Accounts payable ............................................................................3,846

Income taxes ....................................................................................1,754

Accrued liabilities ............................................................................1,314

Current portion, term debt ................................................................1,564

Total current liabilities .................................................................8,794

Long-term debt, less current portion ...................................................17,742

Deferred:

Income taxes ....................................................................................982

Franchise fees ..................................................................................3,730

4,712

Stockholders' equity: ...........................................................................

Common stock, $0.10 par .................................................................676

Capital in excess of stated value .......................................................9,726

Retained earnings ............................................................................12,766

Total stockholders' equity .....................................................................23,168

Total liabilities and stockholders' equity$54,416

Figure 2

INCA, INC.

Present Value of Cash Flows

(in thousands)

Restaurant SizeLevel of DemandOutcomes (NPV)

StandardHigh (.40) ................................$1,050

Medium (.40) ................................630

Low (.20) ................................(200)

ExpandedHigh (.40) ................................2,812

Medium (.40) ................................740

Low (.20) ................................(900)

Management believed that restaurants with a capacity of 144 persons would be more profitable than the present size of 81.

The company faced two choices: continuing with the smaller-size units or going to the larger size. The initial cost for five smaller restaurants was $2.1 million, and it was $3.7 million for five larger ones. Demand expectations over the years were 40 percent for high demand, 40 percent for medium demand, and 20 percent for low demand. The net present values of cash flows for the two proposals are given in Figure 2.

John H. Porter had been president and chief executive officer of Inca, Inc., since July of 2005. Prior to that time he had worked for a competitor. He knew the decision concerning the size of new restaurants could be a major turning point for the company. Mr. Porter wondered if the potential higher returns for the larger units justified the increased risk. In any event, the strategy would have to be sold to the board of directors.

Required

1. Determine the expected value of the net present value for the standard-size restaurants. Use the data in Figure 2. To get the expected value, multiply the outcomes (NPV) times the appropriate probability (.40 for high demand, etc.). for high demand, medium demand, and low demand, and sum to answer this question. Remember to state your final answer in thousands.

2. Follow the same procedure for the expanded-size restaurants to arrive at the expected value of the net present value.

3. Which alternate appears to be the more desirable?

4. Next, determine the standard deviation for the standard size restaurants. Remember to state your final answer in thousands. The standard deviation for the expanded-size restaurant is $1,415,800.

5. Now determine the coefficient of variation for the two alternatives.

6. Based on the coefficient of variation, which of the two alternatives is more desirable? Comment on the relationship of your answer to question 3 and your answer to this question. What general principle is being demonstrated?

7. Assume, in addition to considering the building of five restaurants that are all standard or all expanded, Inca evaluates possible combinations of the two. The following values will apply for the expected values and the standard deviations.

Standard DeviationExpected Value

4 standard, 1 expanded .....$ 641,630$ 753,760

3 standard, 2 expanded .....832,460875,420

2 standard, 3 expanded .....1,025,800997,280

1 standard, 4 expanded .....1,220,4001,119,040

If the firm wishes to minimize risk, which of the six alternatives should it choose? (Refer to your answer to question 5 as well as this question.)